Economic Growth Factors

Section: Economic Growth Factors Estimated study time: 60 minutes Content: Economic growth analysis at CFA Level 2 builds on the Solow growth model and extends into total factor productivity, human capital theory, and the determinants of long-run per capita income. The Solow model (also called the neoclassical growth model) decomposes output growth into contributions from capital accumulation, labor growth, and total factor productivity (TFP). The production function takes the form: Y = A * F(K, L), where Y is aggregate output, A is total factor productivity (a measure of technology and efficiency), K is physical capital, and L is labor. Under the Solow model, capital accumulation alone cannot sustain long-run growth because of diminishing marginal returns to capital — each additional unit of capital adds less output than the previous one. Only sustained growth in TFP (technological progress) drives long-run per capita income growth. Growth accounting decomposes the observed GDP growth rate into factor contributions. Using the Cobb-Douglas production function: Y = A * K^alpha * L^(1-alpha), growth accounting yields: %ΔY = %ΔA + alpha*%ΔK + (1-alpha)*%ΔL, where alpha is capital's share of output (typically 1/3 in advanced economies). TFP growth (%ΔA) is the residual — the portion of GDP growth not explained by capital or labor growth, sometimes called the Solow residual. At Level 2, candidates must apply growth accounting to decompose historical growth, compare growth sources across countries, and evaluate whether growth is sustainable (TFP-driven) or temporary (investment-driven). The steady state in the Solow model is the long-run equilibrium where capital per worker is constant — investment exactly offsets depreciation and labor force growth. In the steady state: s*y = (delta + n)*k, where s is the…